Cathay Dupont Award: What is Behind Cathay General Bancorp’s (CATY) Superior ROE? Edit Title

Over the past 12 months, Cathay General Bancorp (NASDAQ:CATY) generated an ROE of 9.8%, implying the company created 9.8 cents on every dollar of shareholders’ invested capital. While Cathay General Bancorp turned out to be more efficient than its industry, which delivered a Return on Equity of 9.3%, there are other factors to consider before we call it superior.

Peeling the layers of ROE – trisecting a company’s profitability

ROE ratio basically calculates the net income as a percentage of total capital committed by shareholders, namely shareholders’ equity. Generally, an ROE of 20% or more is considered highly attractive for any investment consideration. Although, it’s more of an industry-specific ratio as the constituents share similar risk profile.

Return on Equity = Net Profit ÷ Shareholders Equity

For a company to create value for its shareholders, it must generate an ROE higher than the cost of equity. Unlike debt-holders, there is no predefined return for equity investors. However, an expected return to account for market risk can be arrived at using the Capital Asset Pricing Model. For CATY, it stands at 8.75% versus its ROE of 9.8%.

ROE can be broken down into three ratios using the Dupont formula. The profit margin is the income as a percentage of sales, while asset turnover highlights how efficiently Cathay Dupont Award a company is using the resources at its disposal. Increased leverage, primarily through raising debt, is good for a profitable company, but only to the extent it doesn’t make the firm insolvent in a time of crisis.

Dupont Formula

ROE = annual net profit ÷ shareholders’ equity
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = profit margin × asset turnover × financial leverage

A trend of profit growing faster than revenue is indicative of improvement in ROE. While investors should assess the past correlation between them, an assessment of the analysts’ profit and revenue forecast points to the most likely scenario going forward. The asset turnover for a capital intensive industry such as bricks-and-mortar retail would be substantially lower than the e-commerce retail industry. A comparison with the industry can be drawn through ROA, which represents earnings as a percentage of assets. Cathay General Bancorp’s ROA stood at 1.3% in the past year, compared to the industry’s 0.98%. Read Cathay Dupont Award articles here...

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